European Regulators Mull Ban on Short Selling

Stephen Castle and Louise Story|The New York Times

Thursday, 11 Aug 2011 | 4:29 PM ETThe New York Times

SHARES

A European market regulator is considering recommending a temporary ban on negative bets against stocks across the continent in an effort to stop the tailspin in the markets, according to two people with knowledge of government discussions.

The European Securities and Markets Authority (ESMA), a body that coordinates the European Union’s market policies, has been requesting information from member states about such bets against stocks, known as short-sales.

In such deals, a trader sells borrowed shares in hopes that they will decline in value before he has to buy them back to close out his loan. The difference in price is his profit. Critics say short selling encourages speculation and pushes stock prices down, sometimes feeding on itself in a panicked market, while advocates say it keeps the market honest and maintains liquidity.

“We are discussing with national authorities and together we will decide whether we need coordinated action,” said Victoria Powell, a spokesperson for the ESMA. She declined to comment on the timing of any decision or its possible scope.

The two people knowledgeable about the discussions said the authority might propose a ban on betting against all stocks or just financial stocks. It also may propose a ban on a certain type of short selling in which the party making the negative bet does not borrow the share it is shorting first. The bans would likely be temporary, just to calm the markets.

Such a policy would add to the list of parallels commentators are making between the current market panic and the financial crisis of 2008.

Back then, several governments including Britain and the U.S., banned short-selling on financial stocks temporarily. The ban was meant to help bank stocks from falling further, but in time, stocks fell anyway. Hedge funds, in particular, were hurt by the ban because it interfered with lots of trading strategies that pair negative bets with positive ones.

Earlier this week, Greece banned short selling for the next two months on all of its stocks. Ms. Powell said that the ESMA began consulting national regulators when it was informed by Athens about the impending move.

South Korea also began a three-month ban this week, and Turkey, where the main index has fallen nearly 20 percent this month, moved on Thursday to curb short selling as well, Bloomberg News reported.

The ban on short-selling in 2008 has been widely criticized ever since and blamed for driving investors out of the market altogether, further hurting stock prices.

It is impossible to know whether the panic would have been worse without the ban, which protected companies like Goldman Sachs and Morgan Stanley, but general studies of short selling have found that bans on that activity can lead to more volatility in the market and lower trading volume, according to Andrew W. Lo, a professor at the Massachusetts Institute of Technology.

Lo said removing short-selling also removes important information about what investors think about the financial health of companies, and suggested the bans serve mainly political purposes.

“It’s a bit like suggesting we take heart patients in the emergency room off of the heart monitor because you don’t want to make doctors and nurses anxious about the patient,” Mr. Lo said.

The ESMA does not have the authority to impose a policy on short-selling but it can make recommendations and coordinate cooperation among the European Union’s 27 governments. The European Parliament is considering legislation to give ESMA additional powers.

Some investors are already anticipating that such a ban may occur, said Robert Sloan, managing partner of S3 Partners, a firm that helps hedge funds manage their relationships with their brokers.

Sloan said that for the last two months many investors have been getting out of their short positions in part out of fear that such a ban might be introduced.

He also said if there were more short-sellers in the market now, the markets might be falling less than they are. That’s because as markets fall, short-sellers often close their positions to cash in profits and in doing so, they have to purchase shares to cash out.

The markets could use these sorts of buyers now, said Mr. Sloan, who wrote a book after the 2008 crisis called “Don’t Blame the Shorts: Why Short Sellers Are Always Blamed for Market Crashes and How History Is Repeating Itself.”

Arturo Bris, a professor of finance at the IMD business school in Lausanne, Switzerland, studied financial stock prices in 2008 before and after a short-selling policy was put in place. On Wednesday, Bris said that he did not think such a ban in Europe would help in the long run.

“If there is a ban in the European markets in the next couple weeks it would stop the blood, but it’s not going to solve the problem. It would just delay the problem,” Bris said.

Even if Europe does ban short sales of some stocks, investors who are negative on companies may still find ways to bet against them in the derivatives market, if those sorts of trades remain allowed.